Why the internet economy isn't immune from recession

The prospects for the global economy in 2008 are looking about as promising as Britney Spears’ career, especially after yesterday’s plunge.

But VCs aren’t concerned - they invested $29.4bn last year (pdf) across 3,813 deals and raised $34.7bn in 2007 for future investments.

What’s the justification?

The industry’s optimism stems from a belief that many of today’s hottest concepts either are recession-resistant or are developing moneysaving products that may have even more appeal during an economic downturn.

Are the VCs' favourite internet properties (i.e. Facebook, Twitter, Slide and Digg) really recession-resistant? Not likely, given that they’ve had a hard enough time effectively monetising during an up-cycle.

While I’m not prepared to pass judgment on investments in non-internet sectors, I will pass judgment on investments in the internet sector: VCs who continue to invest in Internet startups, particularly the Web 2.0 kind, thinking them “recession-resistant” are naively optimistic at best.

I’ve laid out why I think the recession is going to pose some significant challenges to Internet startups, especially those that are dependent on advertising revenues.

In a recent interview I read, one VC acknowledged that advertisers will cut their budgets during a recession but argued that money would flow to internet startups because the cuts would occur primarily in non-internet ad budgets and that those savings would be transferred to online advertising spend.

Given that internet advertising, in general, isn’t much more effective (if it’s more effective at all) than advertising in other mediums for most major advertisers, I think this is a naive assumption. If the economy continues to decline precipitously, there will be cuts across the board and internet companies will definitely notice.

Let’s put things into perspective using the US economy (even though other countries, such as Britain, are facing similar problems):

• The subprime mortgage market is in total meltdown and the extent to the damage this is going to cause is not yet known. What does seem clear is that the pain is far from over, especially as it becomes clear that there are lots of other nasty contributors to the meltdown. Even prime loans may not be immune from the problems.
• The subprime meltdown has caused a major liquidity crisis that the central banks have been unable to deal with effectively even though they’re printing more money at full blast. It’s likely that the Fed will cut interest rates by a full point, which risks pushing inflation even higher and further promoting the decline of the US dollar. The central banks, however, don’t seem to realise that one of the reasons their continued intervention has not been effective is that we’re no longer simply dealing with a problem of liquidity, we’re also facing a solvency crisis. Liquidity and solvency are two different beasts.
• The stimulus packages desperate politicians are promoting, which amount to little more than a bailout attempt by a broken government, aren’t likely to work either. 
• Mortgages Gone Wild is spilling over into other areas and the amount of money at stake is staggering. Credit cards and auto loans are looking shaky as consumers start to hunker down under the pressure of the collapsing housing market which had for so long fuelled their over-indulgences. The bond market is potentially another disaster waiting to happen. MBIA and Ambac Financial Group, the two biggest bond insurers, are teetering on the verge of bankruptcy. In the words of Michael Metz, chief investment strategist at Oppenheimer Holdings:

“Sub-prime is only Act One. The next act is auto loans and consumer credit. After that is home equity loans. After that is commercial real estate. After that come the private equity deals of the last two years at extraordinary levels of valuation and leverage.”

• Even the carry trade is a potential source of further trouble. In some parts of the country, it’s starting to look more like the Grapes of Wrath.

• The only real hope right now is foreign investors, primarily sovereign investment funds. Their increasing ownership of major American companies has some concerned about the long-term implications: an America that really isn’t owned by Americans.

In an article entitled “Day of reckoning is almost here”, Patrick Buchanan observes:

"This self-indulgent generation has borrowed itself into unpayable debt. Now the folks from whom we borrowed to buy all that oil and all those cars, electronics and clothes are coming to buy the country we inherited. We are prodigal sons, and the day of reckoning approaches."

So where does this leave the internet? I’m a big believer in the importance of “the big picture” and think that even though the 'internet economy' at times seems disconnected from the real economy, it makes sense for everyone involved in the world of internet business to keep an eye on this big picture.

When looking at the totality of today’s economic landscape, I find it hard to get excited about the prospects of the recent crop of internet startups and the new ones that are being created as we speak.

The truth is that the economic prosperity of the past decade has been an illusion created by debt and complex financial instruments. The illusion is fading fast and this is going to have an impact on our daily lives, both as individuals and professionals.

In my opinion, there is no question that consumer internet startups are eventually going to feel the pain along with consumers.

Startups like Facebook and Slide are not recession-proof because they’re dependent on advertising budgets that had swelled due to strong consumer spending and now that the party is over (and advertisers are finally starting to demand more for their money), these startups have reason to worry.

In the case of Facebook especially, talk of an IPO seems asinine given the condition of the financial markets. Even if the company doesn’t plan to go public in 2008, looking ahead to 2009 or 2010 seems pointless given all the uncertainty.

VCs (and internet entrepreneurs) should be concerned about the global economy. Those who say they aren’t are either lying or are completely stupid.

It’s going to be survival of the fittest, and internet startups have two options -hunker down and find a way to survive or hope that somebody buys you before things really get ugly.

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